Stop Order

A Stop Order is an instruction you give your broker to buy or sell a security once its price reaches a specific, predetermined level, known as the stop price. Think of it as a conditional trigger. Once the stock hits your stop price, your order is activated and becomes a market order, which means it will be executed at the next available market price. This tool is often used by traders to either limit potential losses or to lock in profits on an existing position. However, it’s a tool that should be handled with extreme caution, especially by those following a value investing philosophy.

Stop orders come in two primary flavors, each serving a different purpose. Understanding both is key to seeing the full picture.

This is the most common type of stop order. Imagine you buy shares of “Clever Clocks Inc.” at $50 per share. You're happy with the purchase, but you want to protect yourself from a significant drop. You could place a stop-loss order at $45. If the stock price falls to $45, your order is triggered, and your shares are sold at the best available price. It sounds like a perfect safety net, right? Well, not always. The biggest risk is slippage. When your stop price of $45 is hit, it triggers a market order, not a guaranteed sale at $45. If the market is crashing and prices are plummeting, the next available price might be $44, $43, or even lower. You wanted to get out at $45, but you ended up selling for much less. For more control over the execution price, some investors use a Stop-Limit Order. This two-part order has a stop price that triggers the order and a limit price that defines the worst price you're willing to accept.

Less common, but still useful in certain strategies, is the buy-stop order. This is an order to buy a security when its price rises to a specific level. Why would you want to buy at a higher price? Proponents of technical analysis use this to capitalize on momentum. They might believe that if Clever Clocks Inc., currently trading at $55, breaks through a resistance level of $60, it's destined to soar much higher. They would place a buy-stop order at $60.05 to automatically purchase shares and ride the wave up.

So, should a value investor use stop orders? In most cases, the answer is a resounding no. Value investing, the philosophy championed by legends like Benjamin Graham and Warren Buffett, is built on a simple premise: buy wonderful companies at fair prices and hold them for the long term. Your decision to sell should be based on a change in the company's fundamental intrinsic value or business prospects, not on the fickle whims of the market. As Buffett famously said, “The stock market is a device for transferring money from the impatient to the patient.” A stop-loss order is, by its very nature, an instrument of impatience. It forces you to sell based purely on price, which is exactly what a value investor tries to ignore. In fact, a savvy value investor sees a significant price drop in a great company not as a reason to sell, but as a fantastic opportunity to buy more at a discount! Selling a fundamentally sound business just because its stock price temporarily dips is like selling your house because your neighbor offered you 20% less than you paid for it last year. While a stop order might provide a false sense of security, it can ultimately kick you out of a great long-term investment at the worst possible time.

• A Stop Order is a trigger to buy or sell a stock at the next available market price once a certain price level is reached.
• A stop-loss order is used to sell a stock if it falls, aiming to limit losses.
• A buy-stop order is used to buy a stock if it rises, aiming to catch upward momentum.
• Beware of slippage! The execution price is not guaranteed and can be worse than your stop price in a fast-moving market.
• For value investors, stop orders are generally counterproductive. Your buy and sell decisions should be based on business fundamentals, not on daily price fluctuations. A falling price for a good company is often a signal to buy, not to sell.